Turkish inflation drives consumers to incur extreme shoe-leather costs

Inflation imposes costs on people. One of the costs of inflation is that it gives people strong incentives to spend time and effort avoiding higher prices. They can do that by reducing their cash holdings, searching harder for low prices, or, in extreme cases, travelling to shop elsewhere. When inflation is high, and prices are increasing rapidly, consumers have a strong incentive to spend a lot of time doing these things. Economists call these shoe-leather costs, because when consumers have to walk around a lot of stores in order to compare prices, their shoes wear out. At least, that's a literal explanation of the term. In an age where prices are published online, the actual act of 'walking around to compare prices' is a lot easier on the shoes. Or is it? An extreme example has been playing out recently, as reported in Bloomberg last November (paywalled, but you can find an ungated version here):

Almost every month, Cihan Citak gets into his car, passport in hand, and sets off from Istanbul to Alexandroupolis, a Greek seaside city 40 kilometers (25 miles) from the Turkish border. After a roughly four-hour drive, he walks the crowded aisles of the local supermarket, filling his cart with wine, cheese and other groceries that cost a fraction of what they do back home...

Cross-border retail has become routine for many who found that Turkey’s surging food prices and stronger lira make Greece a cheaper alternative for everyday purchases. The trend, while not new, is accelerating: 6% of all Turks crossing the border to Greece in the first nine months of the year were on a shopping run, the highest share of overall travelers since at least 2012, data from the country’s statistics agency show.

When inflation causes people to drive four hours in order to find lower prices, you know the shoe-leather costs must be high. The inflation rate in Türkiye is over 30 percent. That isn't hyper-inflation, but it is very high. For comparison in New Zealand, the inflation rate spiked at about 7 percent just after the pandemic, but that was the highest it had been in over 30 years. Inflation more recently has been between 2.5 and 3.5 percent, which is higher than the Reserve Bank's mandate to keep inflation between one and three percent in the medium to long term.

All of that is to say that Türkiye’s much higher inflation creates much stronger incentives for consumers to incur shoe-leather costs to avoid higher prices than is currently the case in New Zealand

[HT: New Zealand Herald, also paywalled]

How important are petrol prices for inflation and inflation expectations

Many goods and services make up the consumer bundle that is used to measure the Consumer Price Index (CPI) and inflation. However, some of those goods are weighted more heavily in the bundle, because they make up a higher proportion of the average consumer's spending. One example is petrol. 'Private transport supplies and services', which includes (among other things) petrol, makes up 7.27 percent of the consumer bundle (and this Stats NZ page also suggests that petrol is 3.5 percent of the CPI).

Petrol is also one of the most visible prices. Many of us would see the petrol price every day, on the large fuel price boards outside service stations. So, from the perspective of a consumer, a change in petrol prices will likely be an important contributor to how inflation feels, both because petrol is something that consumers spend a lot on, and because the petrol price is something that is very visible.

How important are petrol prices to inflation, and to consumers' inflation expectations? That is the question that this 2024 article by Puneet Vatsa (Lincoln University) and Gabriel Pino (Universidad Diego Portales), published in the journal Energy Economics (open access), attempts to answer. Vatsa and Pino use data from 1995 to 2023 on petrol prices (from the Ministry of Business, Innovation and Employment), CPI inflation (from Stats NZ), and one-year (and five-year) inflation expectations from a quarterly household survey run by the Reserve Bank of New Zealand. They analyse the data using structural vector autoregression (SVAR) models, which are basically just fancy time series models that try to estimate how different variables move together over time, and figure out which changes are likely to cause which effects.

Using this method, Vatsa and Pino find that:

...petrol price shocks explained 32.61 % of the variation in the quarterly headline inflation rate from 1995 Q1 through 2023 Q3; they explained 34.05 % of the variation in one-year inflation expectations over the same period.

So, even though petrol makes up less than four percent of the CPI, changes (shocks) in the petrol price explained nearly one-third of the change in the CPI over that 28-year period. Part of that will be that petrol prices change frequently, so a lot of the fluctuations in the CPI will be due to fluctuations in petrol prices. Another part will be that petrol prices affect transport costs (or rather, diesel prices, which are highly correlated with petrol prices, affect transport costs), which in turn affect the prices of lots of other goods and services. This latter effect is demonstrated by Vatsa and Pino, who show that core inflation (which excludes petrol) is also affected by petrol price shocks, but to a much smaller degree, explaining 7.79 percent of the change in core inflation.

Consumer expectations about future inflation are also significantly affected by petrol price shocks. However, Vatsa and Pino find that this is true only of expectations about inflation one year into the future, but not for five-year inflation expectations. They don't offer a good explanation of why the effect of petrol prices on consumers' inflation expectations is only for short-term expectations. However, it is likely that immediate price changes affect consumers short-term beliefs about inflation, whereas their long-term beliefs about inflation are anchored by long-term policy, such as the Reserve Bank's goal of maintaining low and stable inflation. Maybe.

Overall, this paper shows the importance of petrol prices for consumer inflation in New Zealand. So, if you want to know what is happening to inflation, and to inflation expectations, take a closer look each time you fill up your car (it is likely better than relying on the media).

Michael Ryan on whether fighting inflation always leads to recession

We've just finished teaching the macroeconomics section of ECONS101 for this trimester (which brings our teaching to a close). The last week covers the Phillips Curve - the empirically-observed short-run trade-off between inflation and unemployment. The implication of the Phillips Curve is that if the government wants to reduce inflation, it can do so only at the cost of higher unemployment. And if the government wants to reduce unemployment, it can do so only at the cost of higher inflation.

My colleague Michael Ryan wrote on The Conversation recently on the topic of whether fighting inflation leads to recession. He wrote:

But are reductions in inflation inextricably linked to recessions?

New Zealand’s own economic history, it turns out, can give some guidance on this, and point to the risk factors within the country’s economic outlook...

Since 1961, New Zealand has experienced eight falls in inflation (disinflations) of four percentage points or more. (Disinflation refers to when inflation drops but remains positive, while “deflation” occurs when the inflation rate falls below zero).

This four percentage point drop is required for New Zealand’s inflation to reach the Reserve Bank’s target of 1-3%, down from the 7.3% recorded in the third quarter of 2022...

Then, after looking at New Zealand's history of periods of disinflation since 1960, he concludes that:

The message is a positive one: a fall in inflation does not necessarily have to be associated with a recession.

That was a bit of a relief to me, given that I wrote at the end of 2022 (also in The Conversation) that the Phillips Curve relationship is not causal, but that nevertheless:

...we can probably expect unemployment to move upwards as the Reserve Bank’s inflation battle continues. Not because lower inflation causes higher unemployment, but because worker and consumer expectations take time to reflect the likelihood of lower future inflation due to the Reserve Bank’s actions.

And since workers negotiate only infrequently with employers, there is an inevitable lag between inflation expectations changing and this being reflected in wages. Alas, for ordinary households, there is no quick and easy way out of this situation.

It is good that Michael Ryan and I are not inconsistent with each other! In theory at least, when the Reserve Bank manages to reduce inflation and unemployment is not negatively affected (that is, the economy doesn't enter recession), it's because inflation expectations have adjusted quickly. That is not always the case.

Higher inflation is modestly associated with higher income inequality

There is a fairly large literature looking at the relationship between inflation and income inequality. Some studies find that there is a positive correlation (more inflation is associated with more income inequality). Some studies find the opposite, a negative correlation (more inflation is associated with less income inequality). Still other studies find no relationship at all between (or, at least, no statistically significant relationship). So, what are we to make of this literature?

To the rescue comes this recent article by Andreas Sintos (University of Luxembourg), published in the journal Economic Systems (sorry, I don't see an ungated version online). Sintos presents a meta-analysis of 124 journal articles, containing 1767 estimates of the relationship between inflation and income inequality. Sintos distinguishes between two strands of the literature: (1) looks at how the level of inflation affects the level of income inequality (in other words, the variables are measured in levels); and (2) looks at how changes in inflation affect changes in income inequality (in other words, the variables are measured in differences). The difference is important. In my view, measuring the relationship in levels doesn't make a lot of sense. If you find that the relationship is positive, then that implies that, since inflation is generally positive, income inequality should be ever-increasing. That seems somewhat inconsistent with reality. In contrast, it seems to me that when the level of inflation changes, that might change inequality.

Anyway, Sintos finds that:

...once the correction for publication bias is made, we find that, on average, inflation has a (small-to-moderate) inequality increasing effect for both level and difference estimates...

In other words, inflation increases inequality (to the extent that we can attribute causality to these results - more on that later in this post). The bias-corrected average effect size ranges between 0.051 and 0.120 (which are interpreted as small and moderate effect sizes respectively). Sintos then goes on to investigate the study-level factors that are associated with the estimated relationship. For the result in differences (which I find more theoretically plausible):

...we find that ten regressors matter significantly for the underlying effect of inflation on income inequality in the primary studies... the BMA [Bayesian Model Averaging] results for difference estimates reveal a decisive effect for eight regressors: GDP deflator, Panel data, Time span, Log transformation, GDP growth, Financial development, Publication year, and Citations. Moreover, we find a strong effect for Trade openness and a weak effect for Education.

Specifically, studies that cover a longer time span, use log-transformed variables, and those that control for GDP growth, financial development, and trade openness find a more positive effect of inflation on inequality, as well as those studies that have attracted more citations. Studies that use the GDP deflator (rather than the change in the Consumer Price Index) as a measure of inflation, use panel data, and those that were published most recently, find a more negative effect (or a smaller positive effect) of inflation on inequality. A couple of things jump out from that. First, the fact that more recent studies, which we would expect to use more sophisticated methods and better-quality data, find smaller effects, should lead us to believe that the 'true' effect is somewhat smaller (less positive) than what Sintos finds on average. However, when Sintos goes on to simulate the effect that would be obtained from the theoretical 'best study', they find that:

The associated prediction, which represents the model average across the models estimated using BMA, is 0.275, with a standard error of 0.115 (95% CI 0.051–0.500), for level estimates, and 0.540, with a standard error of 0.236 (95% CI 0.077–1.002), for difference estimates.

This is somewhat larger than the bias-corrected average effects reported in the paper. That makes me wonder whether the assumption that studies are improving in quality over time actually holds. Could it be that more lower-quality studies, or perhaps studies with lower-quality data, are increasingly being published? We don't have a direct answer to that question, but the correlation matrix reported in Figure 2 in the paper suggests that more recent publications are less likely to use OLS regression, and more likely to control for the variables that have important effects (as noted above). So, I remain somewhat at a loss to explain why the 'best study' estimates are larger than the bias-corrected average effects.

Second, the fact that studies that report more positive results have attracted more citations should be a bit of a concern. The literature had a diversity of results, and while the bias-corrected average effect is positive, that in itself shouldn't lead researchers to cite papers with positive effects more than those with the opposite, or with null effects. There is clearly a bit of cherry picking going on in terms of what results are cited in the literature.

Finally, the results don't establish causality definitively. Many of the studies deal with endogeneity problems, but not all of the studies do. So, while we can tell a plausible causal story here, we can't be sure about it. Nevertheless, this paper is another model of reporting meta-analytic results, the second such paper that I've read this year (see here for my post about the other paper). Given the importance of meta-analysis for estimating the average effect across a literature as a whole, the trend towards clearer exposition and interpretation of the results of meta-analyses is very welcome.

What we can take away from this paper is that higher inflation is modestly associated with higher income inequality. Given the sheer number of things that appear to be correlated with inequality, it would be expecting too much for inflation to have a large effect. But nevertheless, when we consider income inequality, inflation (or change in the inflation rate) appears to be an important consideration.

The political cost of inflation in India

The costs of inflation is a common topic in introductory macroeconomics. We cover it in ECONS101. The challenge in recent years has been getting students to understand inflation at all. After around three decades of low inflation, it just hasn't been really relevant until quite recently. Now, the costs of inflation are becoming all too apparent.

However, one cost that we tend to overlook is the political cost. High inflation can be quite damaging to the political party in power at the time, as increases in the cost of living cut into voters' pay and erode their savings. This has been the case in New Zealand, but appears to be even more the case in India, as noted in this Financial Times article (paywalled) from July:

Higher food prices have in the past proved politically precarious for incumbent Indian governments, with analysts attributing famous election upsets to anger over high onion prices.

India’s opposition has seized on the latest surge to attack Modi’s government. Mallikarjun Kharge, president of the Indian National Congress, the main opposition party, blamed vegetable price inflation on the BJP’s “loot” and “greed”.

“The public has become aware and will answer your hollow slogans by voting against the BJP,” he said this month...

The BJP remains the favourite in national elections, which are due in the first half of next year, but faces a series of potentially tough state polls in Rajasthan and Madhya Pradesh later this year. It suffered a major setback in May, losing control of Karnataka to Congress.

A disgruntled voting public creates a risk for the government, particularly in an election year. India's ruling BJP party have responded by implementing a rice export ban (in order to lower the domestic price of rice), as well as subsidies, as well as giving out free rice. However:

The BJP’s restrictions on rice exports, designed to appease consumers, have upset another powerful constituency: farmers, many of whom stood to benefit from higher prices.

Swamy K, a 68-year-old rice farmer in a village near Mysuru, said he remained loyal to Modi even though he loathed Karnataka’s erstwhile BJP government. But he said his patience with the party was running thin.

“Politicians keep saying that farmers are the backbone of the country, but that backbone has long been broken,” he said. “They put us on posters, but give us nothing.”

It seems that they are forgetting that farmers are voters too. Or perhaps they are relying on the urban population being much larger, and more likely to vote, than rural farmers. India goes to the polls for their general election in April or May 2024 (the date is yet to be set). However, there are many other countries suffering high inflation (albeit perhaps not as high as India), with elections to come later this year, including the Netherlands (3 percent inflation rate), Poland (10.8 percent inflation rate), and of course, New Zealand (6.0 percent inflation rate). It will be interesting to see what price the incumbent governments pay (pun intended) for the higher-than-usual inflation rates that their voters have been experiencing.

Read more:

• Fiscal drag as a cost of inflation

Some evidence against 'greedflation' in New Zealand

Last month, Sense Partners wrote a report for BusinessNZ on 'greedflation' in New Zealand. As the National Business Review reported earlier this month (paywalled), when the report was released publicly:

Businesses don’t appear to be using Covid-19 and rampant inflation to cover for ‘super profits’, according to a new report out today.

The research by Sense Partners, commissioned by BusinessNZ, assessed whether ‘greedflation’ was happening in New Zealand.

Greedflation in New Zealand? An imported narrative found while costs have gone up across the board, ‘inflated’ profits were not the catalyst.

You can read the Sense Partners report here. Unlike the flaky PriceSpy analysis that I discussed yesterday, Sense Partners actually looked at how profits and input costs changed over time. They describe the methods very briefly in the report:

We can get a better understanding profit margins and components of price increases from detailed quarterly financial data published by Statistics New Zealand... This data is available for non-financial private sector firms.

We can use this data to analyse profit margins from 2017 to 2022, allowing us to compare pre- and post-Covid periods.

We can also use this data combined with real production GDP data... (a good proxy for quantity unit of output) to calculate sale price per unit, which adds up to the increase in cost of inputs, spend on labour and gross profits.

While gross profits will generate taxes and there will be other expenses such as interest payments or money to cover maintenance for example, this gives us a comparable approach to understanding the drivers of inflation.

The key data come from Statistics New Zealand's Infoshare service here. [*] It provides data by industry on sales (operating income), purchases and operating expenditure, salaries and wages, and operating profit. By comparing the changes in these categories over time, we can get a sense of how much changes in prices (which Sense Partners derive from sales deflated by GDP by industry) are detemined by changes in labour costs (salaries and wages), input costs (purchases and operating expenditure), and profits. The results are summarised for New Zealand overall in the following figure:

Notice that most of the change in prices (the black line on the left, or the brown bar on the right) is explained by changes in input costs (the grey and blue bars on the left, or the top two blue bars on the right). Very little of the change in prices is associated with changes in profits. As the report notes:

We found that, over the three years to December 2022, prices rose by 14% (or an average of 4.6% per year) – 71% of that price increase can be attributed to the increase in input costs, 15% to an increase in labour costs and 14% to an increase in gross profits.

And when looking at different industry sectors:

In the sectors with the highest inflation, input costs was the biggest contributor, not wages or profits.

This leads Sense Partners to conclude that:

We found no evidence of widespread increases in profit margins driving up inflation in New Zealand. It is an imported narrative not supported by the evidence.

One of my pet hates is the tendency for media and other commentators to transplant narratives from other countries to New Zealand. Inequality is one example (there is little evidence that it has been increasing in New Zealand in recent years), and greedflation is clearly another. Of course, I am also sceptical about the case for greedflation in other countries as well, as my previous posts on this topic make clear.

Of course, much could be made about the funder of this research (BusinessNZ) having a vested interest in the results not showing greedflation. Also, the omission of the financial sector, which is often held up as an exemplar of greedflation, is notable. The way that Sense Partners determined price changes (deflating sales revenues by GDP by sector) could also be criticised, as it isn't a direct measurement of price changes. It's difficult to say how much bias that introduces into the analysis. Nevertheless, this report demonstrates that the evidence for greedflation in general is very weak at best. 

*****

[*] At least, I hope the link works. If not, you can find the data by going to Infoshare, then sequentially choosing: Industry sectors; Business Data Collection; and Industry by financial variable.

Read more:

• The case against 'greedflation'
• Noah Smith on the case against 'greedflation'
• How not to identify 'greedflation'

How not to identify 'greedflation'

The blog has been a bit quiet of late, while I've been travelling and working in the UK. However, the real world doesn't stop while you're travelling, and I note that the media have continued their crusade against 'greedflation' while I'm away. In the latest instalment, the New Zealand Herald's Front Page podcast reported last week:

Numbers crunched by the independent cost comparison site PriceSpy show that the impact of inflation is not uniform across all companies.

The data shows that some companies are definitely increasing prices much faster than their competitors, often at a far higher rate than overall inflation figures indicate.

Figures released by Stats NZ showed inflation sitting at 6.7 per cent for the year to March, down from 7.2 per cent in December.

Despite this, the pricing data released by PriceSpy across a number of popular categories showed that some products had increased by as much as 29 per cent when comparing January to May in 2022 and 2023 respectively.

By definition, inflation is an increase in the general price level. That doesn't mean that every price goes up, only that prices are going up in general terms. It should be self-evident that price rises are not exactly the same for all goods and services at all times, and that price rises are not the same for all substitute goods within a particular category at all times. In fact, if all firms increased their prices exactly in concert with each other, we should be deeply concerned about collusion in the market, and no doubt the Commerce Commission would take a dim view of that behaviour.

So, given that firms don't all raise prices at the same time or by the same amount, it should be easy to identify some goods or brands that have risen in price more than others. That is all that PriceSpy has done. They could do this any year, whether inflation is higher or lower, and show something similar. That some firms raised prices more than others isn't evidence of 'greedflation'. It is an observation of the normal way that firms change the price of their products (as I have noted before). If you really believe that there is greedflation, then you need to show that price rises aren't resulting primarily from increases in input costs. PriceSpy hasn't done that (but more on that point in my next post).

And to make matters worse, there is this misunderstanding:

“Our research suggests that inflation may not be the sole factor driving price points up, as we are increasingly seeing competing manufacturers up their prices at differing rates, not only to each other but in comparison to the rate of inflation,” [PriceSpy head of public relations] Lindholm says.

This is proof that you shouldn't get your head of public relations to talk about economics. Inflation doesn't cause prices to go up. Inflation is a measure of how much prices have gone up, in general (on average, if you like). It's like saying that your car's speed is causing your car to go faster.

Anyway, coming back to the original point of this post, I'm still not seeing a lot of convincing evidence for greedflation in New Zealand. The analysis by PriceSpy certainly isn't it.

Read more:

• The case against 'greedflation'
• Noah Smith on the case against 'greedflation'

Noah Smith on the case against 'greedflation'

A couple of weeks ago, I outlined my case against 'greedflation' (broadly, the idea that firms exploit inflation by raising prices to create excessive profits). On the Noahpinion blog this week, Noah Smith has made a related case, closely examining some of the key claims that have recently been made in favour of greedflation and price controls:

Zachary Carter masterfully harnesses the Iconoclast’s Journey in a recent New Yorker profile of economist Isabella Weber. Weber, a professor at UMass-Amherst, is a prominent proponent of the theory many call “greedflation” — the notion that inflation is caused by companies’ monopolistic behavior rather than by macroeconomic factors, and that the proper solution to this is price controls...

In addition to the policy ideas around price controls, Weber is a proponent of the idea of “greedflation”. Her paper with Wasner has a theory of what that means, and how it’s supposed to work. The theory is basically game-theoretic — it relies on ideas about strategic interactions between companies that end up causing inflation at the macro level. But because the game structure is not explicitly specified, it’s difficult to tell exactly how Weber thinks the strategic interaction is working. For example, on p. 189, Weber writes:

Firms do not lower prices, as doing so may spark a price war. Firms compete over market shares, but if they lower prices to gain territory from other firms, they must expect their competitors to respond by lowering their prices in turn. This can result in a race to the bottom which destroys profitability in the industry. Price wars are very risky for firms that are already in the market and are therefore typically launched by new entrants.

This leaves me with many questions. Do Weber and Wasner think incumbent firms never lower prices? (That’s obviously wrong.) Or do they just not lower prices in specific situations? What’s different about the situations where firms refuse to lower prices? What does it mean to “gain territory” from other firms, and how does that work? Where does the “race to the bottom” end? And so on. Mainstream economists specify the answers to these questions by writing out strategic interactions explicitly in the form of game theory; this approach certainly has its drawbacks, but at least it allows the reader to start to think about how to falsify or confirm the theory being presented.

And how is the above assertion supported? Weber and Wasner cite A) a number of economists from the early 20th century, whose observations of markets she claims to have distilled, and B) recent earnings calls by a few public corporations. I would not label this support “crap”, but neither do I believe that it’s sufficient to support the assertions about how strategic pricing interactions work. Sraffa, Kalecki, Galbraith, Robinson, etc. were all very smart people, and I am sure their close observations of firm behavior were useful and carefully made. But they were working decades ago, without the benefit of modern empirical data collection methods and analysis techniques; a lot of important work on strategic interaction between companies has been done since the 1950s, and I think Weber and Wasner should take it into account. The strategic landscape businesses face may have changed as well. As for corporate earnings calls…public-facing corporate statements can offer clues as to how companies behave and interact, but that’s more of a jumping-off point for the development of a theory rather than evidence confirming a theory.

The whole paper is like this, more or less. It feels like a proto-theory — a collection of ideas that might offer a good description of how pricing works in a modern economy, but one that needs to be made more concrete before we can properly evaluate how accurately it describes reality. And we should definitely test any theory as best we can, before using it to make policy.

For broader context, you should read Noah's whole post. As I noted when I was interviewed for RNZ's The Detail podcast last month, the evidence that proponents cite for 'greedflation' seems to be a case of 'I know it when I see it'. As Smith strongly implies in his blog, that isn't a strong and falsifiable theoretical basis for an idea that leads people to prefer strong policy, and potentially catastrophic, responses like price controls. Do we really want to have to resort to the black market to buy milk and toilet paper, as Venezuelans had to in 2015 as a result of price controls? We need to be very careful before adopting a policy that prioritises price controls to deal with inflation. As far as I can see, the proponents of the greedflation idea are not showing that level of care. And with glowing (and unwarranted) attention from some sections of the media, why would they?

[HT: Marginal Revolution]

Read more:

• The case against 'greedflation'

The case against 'greedflation'

The latest economics buzzword is 'greedflation' - the idea that firms exploit inflation by raising prices to create excessive profits (for example, see here). Aside from being a cool portmanteau and inspiring new memes, I just don't see it. In fact, I've said so. I wrote an article in The Conversation about it last month, and I was interviewed on RNZ's The Detail podcast last week (see also here, and similar points picked up by the New Zealand Herald's Front Page podcast here). I was pretty clear on The Detail - I'm a greedflation skeptic. This post outlines the theoretical and practical reasons why I believe that greedflation is an illusion.

First, let's consider how firms price their products. As I teach in my ECONS101 class, we assume that firms with market power are trying to maximise profits. If the firm sells a single product at a single price-per-unit, the profit-maximising quantity is the quantity where marginal revenue is exactly equal to marginal cost. As shown in the diagram below (which assumes a constant-cost firm, a point I will return to later), the profit-maximising quantity is QM. To sell the quantity QM, the firm sets the price equal to PM, because at that price the quantity of the product that consumers want to buy is exactly equal to QM. The difference between the price PM and the firm's costs PS is the firm's mark-up. The firm's producer surplus (profit) is equal to the area of the rectangle CBDF.

Now, once the profit-maximising price is set, there is no reason for the firm to deviate from that price. If the firm raises the price above PM, then by definition their profits must decrease (because PM is the price that maximises profits, so any other price must decrease profits for the firm). So, here we have the first theoretical case against greedflation - a firm that is already profit-maximising has no incentive to increase prices, because they are already maximising profits. It makes no sense for the firm to try and 'trick' consumers into paying a higher price, because consumers would buy less of the good.

Now, consider what would cause the firm to change the price it sets. First, a firm would likely change prices if its costs change. This is shown in the diagram below. If the firm's costs decrease from MC0 to MC1, then the profit-maximising price decreases from P0 to P1. This also works in reverse - if the firm's costs increase, then the profit-maximising price increases. This would not be 'greedflation'. Most proponents of the idea agree that a firm that is passing on higher costs to the consumer is not exploiting the consumer. Moreover, the research of Nobel Prize winner Daniel Kahneman and others shows that consumers see higher prices as 'fair' when they are driven by higher costs.

Second, a firm would likely change prices if demand changes. This is shown in the diagram below. When demand is shown by the curve D0, the profit-maximising price is P0, but when demand increases to D1, the profit-maximising price increases to P1, even though costs are the same. Is this 'greedflation'? Perhaps, if the firm tries to hide its increase in price behind a smokescreen of 'it's because of inflation'. Moreover, Kahneman's research (noted above) does show that consumers find price increases that arise from demand changes to be unfair. On the other hand, economists expect firms to increase prices when demand is high. It's how markets work on a routine basis, and isn't unique to a time of higher-than-usual inflation.

Third, a firm would likely change prices if consumers' price elasticity of demand changes. Price elasticity of demand is the consumer's responsiveness to a change in price. When demand is more price elastic, the demand curve is flatter, and the firm's optimal mark-up is lower. This is shown in the diagram below. If the demand curve is D0, then the profit-maximising price is P0, but if the demand curve was more elastic (D1), then the profit-maximising price is lower (P1), even though costs are the same. Why would demand become less elastic? There are many factors that affect the price elasticity of demand. However, most of them are fairly static and don't change much. The availability of substitutes, though, can change. When there are fewer substitutes available, as would happen if competition in the market decreased, that would make demand less price elastic, and raise the profit-maximising price for remaining firms in the market. Is this 'greedflation'? Again, perhaps, if the firm tries to hide its increase in price behind a smokescreen of 'it's because of inflation'. But I'd still argue that this is a routine consequence of a decrease in competition, and not unique to a time of higher-than-usual inflation. This explains the case of Air New Zealand, for example, which has been raised as an example of 'greedflation' in New Zealand. Jetstar wound down its services during the pandemic, reducing competition in the market for domestic air travel, and not surprisingly, Air New Zealand raised domestic airfares.

Ok, so we've established the conditions where firms with market power would increase prices (higher costs, higher demand, lower competition). However, as I note in my ECONS101 class, pricing in the real world is not as simple as that shown in the diagrams above. First, firms often don't know for sure what their demand curve is, and so they won't know for sure what their marginal revenue curve is, and so setting the price at the quantity where marginal revenue is exactly equal to marginal cost is difficult in practice. However, that doesn't mean that firms can't set a price at all. It just means that they can't always do it perfectly. A good manager has a fundamental understanding of their market, which means that they understand in relative terms how price elastic or price inelastic the demand for their product is. They can use that fundamental understanding to set the mark-up. They won't get it perfectly correct, but they shouldn't systematically get it wrong (if they did, they wouldn't be a manager for long). Then having set the price using their fundamental understanding, they adjust the price occasionally to take account of changing costs or changing market conditions. For example, they raise prices if their costs increase, or they lower prices if a new competitor opens down the street from their store.

Second, firms don't change their prices every time that market conditions change. That's because of menu costs - literally, the costs associated with changing prices. Menu costs may be low if all they require is changing some settings in the point-of-sale system, but can be higher if they require printing and attaching new price labels. Firms prefer to avoid these costs, as well as avoiding the uncertainty for consumers that constantly changing prices cause, so they tend to increase prices only infrequently.

Both of those real-world pricing problems mean that firms will often increase their prices by more than is justified by a strict accounting of an increase in their costs. Perhaps they are 'catching up' on an increase in costs from a few months earlier. For example, say that the firm has costs that go up from $10 to $12 to $15 from Month 1 to Month 2 to Month 3, but they keep their price the same at $20 from Month 1 to Month 2, and then raise it to $30 in Month 3. If you were looking for 'greedflation', you might then see evidence in favour of it between Month 2 and Month 3, when price increased by 50% but costs only increased by 25%. However, you are ignoring the previous month, when costs increased but the firm didn't change their price.

So, that's the theoretical and practical cases against 'greedflation'. I simply don't think that firms are hiding price rises behind a smokescreen of high inflation. There isn't much incentive for them to do so. Is there empirical evidence to support the idea of 'greedflation'? Quite the contrary. In the latest issue of AEA Papers and Proceedings, this article (ungated earlier version here) by Christopher Conlon (New York University) and co-authors looks at the relationship between changes in firms' mark-ups and changes in prices (as measured by the producer price index, deflated by the consumer price index). They note that:

Our starting point is the observation of Syverson (2019) that for markups defined as price over marginal costs (μ ≡ P / MC), an approximation provides

(1) ΔP ≈ Δμ + ΔMC.

Therefore, increases in markups should yield increases in prices unless they are offset by marginal costs changes.

Using annual data from CompuStat on revenue and cost-of-goods-sold for nearly 8000 firms, and covering the period from 1980 to 2018, as well as quarterly data from 2018 to 2022, Conlon et al. find that their data:

...do not reveal a strong correlation between markup and price changes during the sample periods.

In other words, price changes are not driven by changes in markups, which leaves changes in marginal costs as the explanation. In other words, there is no evidence of 'greedflation'. However, that doesn't mean that changes in competition are implicated solely, either. Conlon et al. note that:

A second explanation, proposed by Syverson (2019), is that if cost of goods is more similar to average costs than marginal costs, then we need to also adjust for the scale elasticity AC/MC,:

(3) μ ≡ P/MC = P/AC × AC/MC

So, if prices are increasing at the same rate as mark-ups, then that could be because average costs are increasing, or it could be because the ratio of average costs to marginal costs is increasing. That would happen if there were a re-balancing of costs from variable costs (MC) to fixed costs (a component of AC). Conlon offer some evidence from other studies that supports this argument. However, that's not 'greedflation' either.

The case against 'greedflation' is strong. Just because it makes a nice meme, that doesn't mean that it is true.

Is it supply, or demand, that has been driving recent inflation?

Inflation is defined as a general increase in the price level. Right now, across the rich OECD countries, we are in a period of historically high inflation. The inflation rates in the US and the UK are both over 8 percent, and in New Zealand the inflation rate was 7.3 percent to the end of June (a 32-year high).

What causes prices to rise? Prices are determined in markets, and in the simplest supply and demand model of the market, an increase in equilibrium prices can be caused by a decrease in supply, or an increase in demand (or both). [*] [**] In the current inflationary period, supply may have decreased because of supply chain disruptions, while demand may have increased because of wage subsidies and other government responses to the pandemic.

That raises the question: how much of the current high inflation is driven by decreasing supply, and how much by increasing demand? That is the question that Adam Hale Shapiro looks at in this FRBSF Economic Letter, published in June. Shapiro first separates items in the personal consumption expenditure basket (used to measure inflation in the US) into those that are supply-driven and those that are demand-driven. As he explains:

Demand-driven categories are identified as those where an unexpected change in price moves in the same direction as the unexpected change in quantity in a given month; supply-driven categories are identified as those where unexpected changes in price and quantity move in opposite directions. This methodology accounts for the evolving impact of supply- versus demand-driven factors on inflation from month to month. 

This categorisation is what we would expect from a supply and demand model of markets. An increase in demand increases the equilibrium price and the equilibrium quantity. A decrease in supply increases the equilibrium price, but decreases the equilibrium quantity. When the quantity doesn't change, it may be that both increase in demand and a decrease in supply are happening (and Shapiro labels those cases 'ambiguous'). 

Then, armed with this categorisation, separating the overall inflation rate into the proportion coming from by demand-driven categories, and the proportion coming from supply-driven categories, is relatively straightforward. The overall picture going back to 2000 looks like this:

Notice that both sources of inflation fluctuate quite a lot, but that demand-driven inflation (the blue bars) fluctuates less than supply-driven inflation (the green bars). Note that recessions (the grey bands in the figure) tend to be characterised by demand-driven deflation (at least after the mid-point of the recession). You can also see the rapid increase in inflation in recent months, and that it has both supply-driven and demand-driven causes (as well as a large increase in ambiguous causes (the yellow bars)). However, the change in supply-driven inflation is larger than the change in demand-driven inflation. As Shapiro notes:

Supply-driven inflation is currently contributing 2.5 percentage points (pp) more than its pre-pandemic average, while demand-driven inflation is currently contributing 1.4pp more. Thus, supply-driven inflation explains a little more than half of the 4.8pp gap between current levels of year-over-year PCE inflation and its pre-pandemic average level. Demand factors explain a smaller share of elevated inflation levels, accounting for about one-third of the difference. The ambiguous category, which is not shown, explains the remainder of the difference.

It would be interesting to see whether the relative contributions of supply-driven inflation and demand-driven inflation are the same in other OECD economies, and whether differences in the drivers of inflation explain the milder inflation being experienced in some countries, when compared with others.

[HT: Marginal Revolution]

*****

[*] Which brings me to one of my pet hates. Inflation does not cause increases in prices. Inflation is a summary measure of price changes across the economy as a whole, not a driver of price changes.

[**] Increases in market power could also cause increases in prices in particular markets. However, it is unlikely that market power would increase sufficiently and simultaneously in enough markets to have an appreciable effect on inflation, despite anything you may have read. Although, market power might exacerbate changes in the inflation rate.

Fiscal drag as a cost of inflation

In my ECONS101 class, we cover the costs of inflation (albeit in the part of the paper taught by Les Oxley). One of the costs of inflation is 'tax distortions', which arises from 'bracket creep'. Apparently, bracket creep can also be referred to as 'fiscal drag'. At least, that is how it is referred to in this recent article in The Conversation, by Jonathan Barrett (Victoria University of Wellington). Barrett explains that:

New Zealand’s income tax system uses progressive rates. Higher slices of income are taxed at higher rates. Every dollar earned up to NZ$14,000 is taxed at 10.5%. Income above that level is progressively taxed higher until the final tax rate of 39% applies to every dollar earned over $180,000.

“Fiscal drag”, sometimes known as “bracket creep”, occurs when an increase in a taxpayer’s income takes their highest slice of income into a higher tax bracket without an increase in real income. This often happens when wages rise to compensate for inflation but tax bands are not adjusted.

Since it is marginal tax rates that matter for incentives, shifting taxpayers into tax brackets with higher marginal tax rates may change their behaviour, without changing their underlying real income. For example, taxpayers may choose to work more (or work less) as a result of moving into a higher tax bracket, than they would have if the brackets had adjusted along with their incomes (and wage inflation), leaving them in the same tax bracket as before. That creates unnecessary distortions in taxpayers' labour market behaviour.

Aside from lower inflation (which would decrease all of the various costs associated with inflation), the solution to fiscal drag is to adjust tax brackets for inflation, otherwise known as 'indexing'. However, it is difficult to get any taxpayer excited about the prospect of indexing tax thresholds. As Barrett notes:

Why do many employees not seem to care about fiscal drag? Perhaps it’s because, psychologically, it doesn’t feel the same as an overt tax increase. Even if the real value of your pay decreases, the amount you take home is stable.

Conversely, index linking may not feel like a tax cut. People understand that prices are rising but they may not necessarily link inflation to their tax levels.

So, unlike some of the other costs of inflation, such as menu costs and shoe leather costs, the costs of tax distortions are a bit less visible to people. In fact, these costs will be almost totally invisible to those who don't change tax brackets. That makes it difficult to convince taxpayers that policy action is necessary. Nevertheless, this is something that warrants greater attention, given that the median weekly earnings of $1189 (for wage and salary earners) is already fairly close to the $70,000 threshold ($1346 weekly) for the 33 percent marginal tax rate. It won't be too long before more than half of salary and wage earners are in that tax bracket, which would seem unnecessary given that their real incomes are not rising.

Economic illiteracy vs. Turkish inflation

The Turkish economy is in real trouble. As news.com.au reported yesterday:

While the rest of the world has tightened monetary policy to deal with the global surge in inflation, Turkey’s central bank has kept its cash rate stubbornly unchanged since January.

In fact it actually cut the rate significantly in the final third of 2021, lowering it from 19 per cent to the 14 per cent at which it now remains.

The central bank has adopted this approach under sustained pressure from Turkey’s President, Recep Tayyip Erdogan, who believes higher interest rates actually fuel inflation.

The conventional economic wisdom is the other way around. It holds that high interest rates restrain inflation, and looser monetary policy inflames it.

Speaking in May, the President defended his gamble and branded those who were concerned about Turkey’s monetary policy “illiterates”.

“Those who try to impose on us a link between the benchmark rate and inflation are either illiterates or traitors,” he said.

Unfortunately, it is the Turkish leader who is the economic illiterate. Low interest rates fuel inflation. That's because when interest rates are low, borrowers need to spend less on interest payments, so that leaves them with more money to spend on other goods and services. Also, businesses can borrow more cheaply to spend on investment goods. Being able to spend more sounds like a good thing, but increasing investment spending, and increasing consumption spending, both increase demand for goods and services. Without a corresponding increase in production, there is essentially more money chasing the same number of goods, and prices start to go up. In other words, inflation increases when interest rates are low. And so, you end up with this:

A year ago, Turkey’s inflation rate was an already troubling 19 per cent. By the end of last month, it had risen to a staggering 79 per cent, the highest it has been in 24 years, and 16 times the central bank’s inflation target of 5 per cent.

Turkey isn't alone in facing high inflation. But it is a substantial outlier:

Incidentally, those viewing the world from London are currently experiencing an inflation rate of 9.4 per cent. Over in New York it is 9.1 per cent.

That’s far more inflation than either country would like – hence, the US Federal Reserve is poised to announce a fresh interest rate hike this week – but it’s preferable to 80 per cent...

According to data released by the Bureau of Statistics this morning, Australia’s consumer price index (CPI) rose by 1.8 per cent in the June quarter, with our annual inflation rate increasing to 6.1 per cent...

For comparison, New Zealand's inflation rate for the year to June 2022 was 7.3 percent, which was the highest level since 1990. That has both economists and lay people worried, but nowhere near as much as inflation of 80 percent would! Those worries arise because there are a bunch of costs associated with high inflation, including:

• Shoe leather costs - the costs to consumers of holding less cash so that they are not exposed to their cash losing value, as well as the cost of time spent searching for the lowest current prices (they are called shoe leather costs because consumers would make frequent trips to the bank to get money, and spend a lot of time searching around for prices, thereby wearing out their shoes);
• Menu costs - the costs to firms of having to constantly adjust prices (they are called menu costs because if your firm is a restaurant, you have to print all new menus when you change prices);
• Arbitrary redistributions of wealth - such as from lenders (who are being paid back in money that is worth less than before) to borrowers;
• Tax distortions - as taxpayers get pushed into higher tax brackets due to their increasing nominal wages; and
• Confusion and inconvenience - since it makes it difficult for anyone to figure out what the current prices are.

Those costs all tend to reduce economic activity, and those costs are going to be far higher in Turkey now than they were before. And all because Turkey's President followed his own (incorrect) ideas about how interest rates affect inflation. I guess we can see who the real economic illiterate is.

There is one small benefit to the current high inflation. Economics teachers will now have students who have actually seen some appreciable inflation, which hasn't been the case for many years. We'll now be able to point to recent experience in our classroom examples.

Devon Zuegel on inflation

One of the interesting (or disturbing, maybe) things about teaching university economics over the last decade or more in a country like New Zealand is that our students have never experienced high inflation. Never. For incoming first-year students next year, mostly born in 2003 or 2004, the inflation rate has only been above five percent (on an annual basis) in two quarters (see the data here) in their lifetimes - in the September quarter of 2008 (5.1 percent) and in the June quarter of 2011 (5.3 percent). The latest data (for the September quarter of 2021) had annual inflation at 4.9 percent. For much of the last two decades (and more) the inflation rate has been under two percent per year. Individual prices may change, but the general price level overall barely moves at all (and it is the change in the general price level that defines inflation).

So, when we teach first-year students about the costs of inflation, we are talking to an audience about something they have never really experienced and can't recognise in the world around them. It's almost like this:

They have no idea, and so menu costs, shoe leather costs, and other costs of inflation are difficult for students to connect with their own experience. We can't use examples from the New Zealand context to illustrate these costs, because New Zealand really hasn't faced those costs in appreciable terms for decades. And jumping straight to examples of periods of hyperinflation (like Weimar Germany, Zimbabwe in the 2000s, or Venezuela more recently), makes inflation seem even more other-worldly to students.

So, I found it interesting to read this perspective from Devon Zuegel on inflation from earlier this week, drawing in part on their experience in Argentina. There is lots of good bits to Zuegel's post, and I encourage you to read it, but I want to focus on two bits on the costs of inflation. First, here (emphasis is theirs):

In turn, systemic uncertainty reduces people's willingness to make long-term investments. (For example, high-inflation Argentina has almost no mortgage industry.) This drawback in investment isn't predicted by the model that my friend had in mind, because the model doesn't take into account the uncertainty that inflation causes or its psychological impacts.

Inflation makes people uncertain about the future value (and purchasing power) of money. It makes lenders less likely to lend money (because they can't be sure about the value of what they will get paid back). You might argue that lenders can build higher expectations about inflation rates into the nominal interest rate they charge to borrowers. This involves recognising the importance of the Fisher equation: real interest rate ≈ nominal interest rate - inflation rate. If the inflation rate is higher, lenders will need to charge a higher nominal interest rate in order to receive the same (target) real interest rate. However, high inflation is also inherently more unstable, and therefore less predictable, so it is difficult for lenders to determine what interest rate they should charge. If they are risk averse, they could err on the side of caution and charge a higher interest rate to protect themselves, but that will deter borrowers and reduce investment in the economy.

Second, Devon notes that inflation creates real harms for everyday people in the economy (emphasis is theirs):

Wage adjustments are not just slow but also uneven across the economy. For example:

• A waiter might do okay when their tips are a percentage of prices, because as long as the restaurant's owner updates prices consistently (which they're very motivated to do), the tip-based wages will adjust accordingly. Their base pay will not adjust so quickly though, because the restaurant owner is unlikely to updated wages as fast as menu prices.

• A retiree with a pension is in a really tough spot, because pensions are rarely (if ever?) indexed to inflation, so over time their income gets eroded to zero.

• Architects are in a tough spot too. They usually charge large lump fees, so if they give you a quote at the beginning of the year and then inflation hits, the real value of the quote they gave you went way down by the time you actually pay for their services.

As a general rule, inflation disproportionately harms people who can't easily adjust their income upwards. Fixed contracts and fixed incomes are especially vulnerable. Wages also don't automatically adjust—you generally need to advocate for yourself to get a raise—so if you lack negotiating skills in a high-inflation economy, you're at a significant disadvantage.

Anyone who can't adjust their income easily is going to be harmed by high inflation. As Zuegel notes, this extends from those on fixed incomes (retirees) if their pensions do not automatically adjust, to people with annual salary reviews (since it takes a year before their salary is revised to account for changes in the cost of living) to contractors. However, it may even extend to day labourers, if their employers are not able to adjust prices frequently and pass on higher wages as a result. Having wages kept low while prices increase also benefits employers, but makes workers want to change jobs in order to lock in a higher wage rate. This 'employee churn' imposes costs on the employer as well as the economy overall.

Inflation imposes costs on people. New Zealanders may have forgotten about these costs (or never experienced them if they are young), but that doesn't make those costs any less real.

[HT: Marginal Revolution]

Book review: Whatever Happened to Penny Candy?

Readers of a certain vintage will remember a time when the cheapest lollies in the local dairy were one cent (in contrast, some younger readers probably never used a New Zealand one cent coin, which along with the two cent coin was demonetised in 1990, while the five cent coin was demonetised in 2006). Now the cheapest lollies are much more expensive (ok, I'll admit I have no idea how much more expensive they are, having long since stopped buying them). Anyway, that is a very long-winded introduction to my latest read, Whatever Happened to Penny Candy?, by Richard Maybury. Penny candy in New Zealand being, of course, the one-cent lolly.

I can't recall who recommended this book to me, but it wasn't quite what I expected. The cover suggests that it is "a fast, clear, and fun explanation of the economics you need for success in your career, business, and investments". That would be accurate, if the economics you needed for success was limited to a thinly-veiled rant against monetary policy and inflation, and in favour of small government.

The book was loaded with "what the f***?" moments, such as this:

Inflation is not the same thing as rising prices.

Actually, it is. The definition of inflation is literally "an increase in the general price level in the economy" (from my ECONS101 textbook, the excellent free e-book The Economy by Core). Or, if you prefer Mankiw (the most widely used introductory textbook), then inflation is defined as "an increase in the overall level of prices in the economy".

To be fair, Maybury does make clear that his definition of inflation is an increase in the number of dollars (that is, effectively an increase in the money supply). And to be fair, that was the original use of the word inflation by economists (for example, see this article by Michael Bryan of the Federal Reserve Bank of Cleveland). However, that is clearly not the current use of the term, and despite Maybury's protestations that governments "have redefined inflation to mean rising prices", it was actually economists that did so, and the change had happened by the 1930s according to Bryan's article. So, Maybury's terminology is at least 80 years out-of-date. The arguments against monetary policy decisions might be valid, but to couch them in outdated use of terminology against virtually all currently-understood use of those terms is a little odd.

Another WTF comes from this:

During a depression, businesses go broke and people lose their jobs. Many become poorer. It's all caused by the inflation.

The first two sentences are correct, and few would argue with them. However, to argue that depressions are caused by inflation not only rejects the idea of monetary neutrality, but is effectively diametrically opposed to it. While strict monetary neutrality is probably not a good description of the real world, there is little evidence to suggest, as Maybury does, that business cycles are caused by inflation (by which he means that they are caused by fluctuations in the money supply).

The book does have some highlights though, including interesting descriptions of Gresham's Law, and the origin of the name of the "dollar" (which dates to the "Joachimthaler" in Bohemia in the Middle Ages, later shortened to "thaler"). However, despite those few highlights, I really wouldn't recommend this book to anyone, least of all anyone who want "a fast, clear, and fun explanation of the economics you need for success in your career, business, and investments".

Does the media help the general public understand inflation?

The media has an important role in helping us to recognise and understand what is going on in the world around us. One of the main goals of my ECONS102 paper is to have students recognise how economic concepts and theories apply to things that are discussed in the media. So, when I read the abstract to this new article, by David-Jan Jansen (De Nederlandsche Bank) and Matthias Neuenkirch (University of Trier, Germany), published in the Oxford Bulletin of Economics and Statistics (I don't see an ungated version, but it might be open access in any case), I took note.

Jansen and Neuenkirch use data from around 1800 people in the Netherlands, over the period 2014 to 2017, and investigate whether their engagement with print media affected the accuracy of their perceptions of current and future inflation. They find:

...no real support for the idea that more-often informed members of the general public do better in understanding inflation. In fact, more frequent readership of some types of newspapers is associated with slightly less accurate inflation perceptions... Also, a set of cross-sectional regressions using data collected in 2017 finds no evidence that non-print media outlets, such as television or Internet, help in understanding inflation. Overall, our paper casts further doubt on the idea that media usage contributes much to knowledge on economic developments...

In other words, the authors argue that the media plays no informative role in helping the general public to understand inflation. However, I disagree for two reasons.

First, the paper is clear that their measure of media use is simply the proportion of newspapers (by type: 'quality' or 'popular') that each person in the sample reported that they used 'frequently' or 'very frequently'. This is hardly a measure of media engagement. It is a measure that mixes up the diversity of news sources the person engages with, with the intensity of that engagement. For instance, there is only one news source that I would report that I engage with 'frequently', so I would show up as a low media user in their sample (in fact, given that it is print media and I don't read print newspapers, I would actually show up as a non-user).

It isn't clear to me what a relationship between incorrect inflation perceptions and the proportion of print newspapers that people read frequently even tells us. It certainly doesn't tell us anything about whether the media helps the general public to understand inflation.

The second issue I have with the paper is their measurement of error in inflation perceptions (and in future inflation expectations). They look at the absolute value of the difference between actual and perceived inflation (or expected future inflation). Actual inflation was taken from the Dutch statistics agency, and perceived inflation was what the respondents thought inflation was in that year (and in the following year, for inflation expectations). The problem here is the use of the absolute value of the error. Let's say that paying attention to media sources makes the general public overestimate inflation. Some people would overestimate inflation, but would overestimate by more if they paid attention to the media. However, other people would underestimate inflation, but by less if they paid attention to the media. In the paper, it appears that most people overestimate inflation, but the conflation of these two groups still potentially creates a serious problem for the analysis.

This is a paper that looks at an interesting research question, but does so in such a way that it doesn't actually answer the research question. It would be reasonably straightforward to replicate this analysis in a more sensible way though, if the authors were willing to share their data (the Dutch DHS household data is freely available online, but the authors supplemented that with their own data collection).

And if the answer is that the print media doesn't help the public to understand economic developments, we could conclude that the public should spend more time reading economics blogs instead.

Inflation for the rich and inflation for the poor

A couple of weeks ago, I wrote a post about Statistics New Zealand's new household living-cost price indexes. Overall, these indexes showed slightly higher inflation for those in the lowest income quintile (the lowest income earners) compared with inflation for those in higher quintiles. Xavier Jaravel (Stanford) has a new paper on a similar topic (using U.S. data). From the abstract:

Using detailed barcode-level data in the US retail sector, I find that from 2004 to 2013 higher-income households systematically experienced a larger increase in product variety and a lower inflation rate for continuing products. Annual inflation was 0.65 percentage points lower for households earning above $100,000 a year, relative to households making less than $30,000 a year. I explain this finding by the equilibrium response of firms to market size effects: (A) the relative demand for products consumed by high-income households increased because of growth and rising inequality; (B) in response, firms introduced more new products catering to such households; (C) as a result, continuing products in these market segments lowered their price due to increased competitive pressure.

More evidence that we should be careful how we interpret the overall inflation rate based on a single Consumer Price Index, and that it is probably appropriate for benefits, superannuation, and the minimum wage to be indexed to the median wage (or a similar measure of income) rather than the CPI.

[HT: Marginal Revolution]

The minimum wage increase and the 'right' measure of inflation

The minimum wage increases to $15.75 per hour on 1 April. The New Zealand Herald had an interesting article yesterday on this:

It will deliver $65m a year in higher wages for the 119,500 people now earning below $15.75 an hour - implying that private employers will have to pay about $35.6m extra on top of the extra cost to taxpayers.

The 3.3 per cent increase from the current minimum of $15.25 a year is at the high end of expectations, considering that consumer prices rose by only 0.4 per cent in the year to last September.

Business NZ urged the Government to keep increases to "no greater than inflation as measured by the consumers price index" until a full review of the minimum wage policy.

Should we be comparing the 3.3 per cent increase in the minimum wage to the 0.4 per cent increase in consumer prices? I argue not, for three reasons.

First, and most obviously, new inflation data out today shows that the annual rate of inflation in the December year was actually 1.3 per cent. But this is far from the most important reason.

Second, the CPI measure of inflation does not take into account the (rapidly rising) cost of home ownership, so certainly understates the increase in the cost of living. And as noted by the New Zealand Initiative, reported here:

New Zealand is not really suffering from an "inequality crisis" but instead a crisis of rising housing costs hurting the poor more than the rich...

That's still not the most important reason though, since I imagine that most people earning the minimum wage are not homeowners (at least, not in Auckland given the out-of-control house prices there!). Rents are included in the CPI, so it probably does reflect changes in the cost of living for renters on the minimum wage.

Third, and most important, the CPI measures the level of consumer prices for all consumers on average. And no one is an average consumer. Fortunately, Statistics New Zealand now publishes a series of household living-cost price indexes. The latest data is from the September 2016 quarter (when overall the CPI increased by 0.3 per cent), so we can expect the latest numbers when they are released to be somewhat higher. The great thing about these indexes is that they show the change in prices experienced by different households, including by income level. This is based on the prices most relevant to households within that group (so you can look at a price index for beneficiaries, superannuitants, etc. as well as by income quintile).

Someone on the minimum wage full-time is likely to be in the lowest income quintile (the bottom 20% of income earners). For the September quarter, their price index increased by 0.5 per cent, which was greater than the 0.1 per cent for all households (and the 0.3 per cent for the second quintile). In fact, in almost all quarters going back to the start of that data in 2009, lower income households have experienced a higher rate of price inflation than all households on average.

So, quite apart from arguing that we should be narrowing the gap between the minimum wage and a living wage (however measured), it is appropriate that the minimum wage rises faster than the overall increase in consumer prices, simply because the prices relevant to lower income households generally have been rising faster than the rate of inflation overall.